“Global Economic Downturn: Where are We? Parallels and differences of Japan and Asia 10 years ago and US now” Takatoshi ITO University of Tokyo 09 February, 2009 Conference on Global Economic Downturn: Lessons and Way Forward ICRIER, New Delhi Takatoshi Ito ICRIER Feb 2009 1 Summary: what happened? • Financial Problem – Started as a US housing bubble burst • Subprime mortgage problem • Securitization was a key – Losses were widely shared by financial institutions and investors around the world – Quickly spread to other securities markets – De-leveraging, financial institutions sell assets and pay back borrowings • Real-side decline – Wealth effects (housing equity, financial wealth destroyed) Æ C decline – Credit crunch, uncertain future demands Æ I decline – Downward spiral of Y, Production, L Æ Recession Takatoshi Ito ICRIER Feb 2009 2 Origin, US Global spillovers US subprime/alt-A housing markets burst Mistrust of financial institutions, various spreads ↑ Damage on US/European Risk spread ↑ Avoid risk financial institutions B/S Globally Stock prices, ↓ De-leveraging: US institutions sell assets abroad and repatriate, US$ ↑ Real side (C and I) decline Real side (C and I) decline Re-coupling, globally, exports to US↓ US recession Global Recession !! Takatoshi Ito ICRIER Feb 2009 3 Subprime Loans and Securitization Origination Distribution Mono Investors line Prime guarantee Banks, Loan Insurance Invest seniority Pension Mortg ment Securi funds $7.0tril. Se tize & age ll banks, senior Alt-A Bank and Resec uritize Loan Banks mezzanine Hedge $1.2tril. Equity funds, Subpri MMFs me Mortgage ** market ABCP $1.5tril. SIV $9.7 tril., * financing end-2006 conduit ** Liquidity Support * Financing Source: Bank of Japan, Financial Stability Report, March 2008 Takatoshi Ito ICRIER Feb 2009 4 Time-line • 2002-2006, Housing boom – Subprime problem started around 2004/05 • Teaser rate Æ two-year time bomb • 2006/07, default rate of subprime increased • 2007, spring/summer, financial institutions reveal losses • 2007 November. CitiCorp and others capital injection from China and Middle-East • 2008, March. Bear and Stearns, rescue merger • TARP, GSE, • 2008, November. Lehman Brothers, bankruptcy, chapter 11 Æ Dramatically changed the scenery • AIG de facto nationalization, government capital injection, MMF guaranteed, interbank liabilities guaranteed, more government capital injection, deposit guarantee • Record decline in various production Æ Fiscal stimulus, Takatoshi Ito ICRIER Feb 2009 5 The rest of presentation: Outline • Opening question • Putting into a perspective: Bubble and Burst: Comparison of the US in 2007-2008 and Japan in 1997-98 – (1) Crisis Mechanism – (2) Crisis Management • What central banks can do beyond global ZIRP? • Will fiscal stimulus work? Takatoshi Ito ICRIER Feb 2009 6 Memorable Quotes, US Treasury Secretary on Japanese NPL • “Why don’t Japanese banks foreclose NPL properties and auction them. Once the bottom is found, real estate prices have only one way up, and the investors will be happy to purchase them” – US Treasury Secretary in a private meeting with economists in Tokyo, sometime during the lost decade of Japan Takatoshi Ito ICRIER Feb 2009 7 Also in Asia • US advice to Asia (1997-98) – Implicit guarantee by the government is a problem. –“Liquidity support” to banks should be stopped. They may be insolvent. Due diligence is important Introduce Mark to market accounting – Do not ban short-selling. Hedge funds are good guys providing liquidity. No reason to regulate. If they attack a currency or company, there is good reason Takatoshi Ito ICRIER Feb 2009 8 (1) Opening Question • It seems that “US now” is NOT following what US told Japan (and Asia) 10 years ago—three possibilities – (A) American advices 10 years ago were totally wrong – (B) Americans are not doing right things right now – (C) The two crises are fundamentally, totally different in nature? Takatoshi Ito ICRIER Feb 2009 9 Housing market Problem • A lot of parallels between Japan, 1985- 2003 and US, 2002-2009 Takatoshi Ito ICRIER Feb 2009 10 Housing (Real Estate) Boom and burst • Japanese housing bubble (1980s) – 3-fold increase in 6 years – All lost in the following 12 years • Is this what will happen in US? – More than double in 8 years – Just lost 20% from the peak Takatoshi Ito ICRIER Feb 2009 11 120. 0 100. 0 80. 0 Land price index for housing, Japan 60. 0 6大都市住宅地価格指数 40. 0 20. 0 0. 0 1971 Takatoshi Ito1973 ICRIER Feb 2009 12 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 S&P Case-Shille r U .S. N a tional Hom e Price Index 200 180 160 140 120 100 80 60 40 20 0 1987 1989 1991 1993 1996 1998 2000 2002 2005 2007 2009 2011 2014 2016 2018 2020 2023 Takatoshi Ito ICRIER Feb 2009 13 Is US following Japanese footsteps? --16 years later 200 120 180 100 160 140 80 120 100 60 80 40 60 40 20 20 0 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Takatoshi Ito ICRIER Feb 2009 14 US housing prices may fall further • Compare the Japanese boom and bust (Land for Housing index) with US boom and bust (Case-Schiller) • Maybe US is only the 3rd inning of the bust process, if the parallel holds • Maybe 700 billion may not be enough, if US starts to buying distressed assets Takatoshi Ito ICRIER Feb 2009 15 (1) Crisis Mechanism • Bubble and Burst – How bubble was formed and encouraged • Starting point, good fundamentals – Why did the authorities not take actions • No other bad signs like inflation • Reason to believe good fundamentals explain a boom Takatoshi Ito ICRIER Feb 2009 16 Root of crisis (1) • Japan •US – Real Estate Bubble – Housing Bubble and and bursting bubble bursting bubble • Both housing and • Mostly housing commercial • Belief in ever-increasing • Belief in ever-increasing housing prices land prices • No check on borrowers • No check on borrowers because of because of secure securitization Ù moral collateral hazard (originate “to” • “Step interest rate loan” distribute) to ease income • Teaser rate for first two constraint years, time bomb • Takatoshi Ito ICRIER Feb 2009 17 Root of Crisis (2) • Japan No •US Securitization securitization – Too complex – Banks kept loans on senior/mezzanine/equi their balance sheet ty, CDOs – Losses hid in – Conflict of interest in subsidiary and credit rating creating accounting – Hid in subsidiary: Potential losses in SIV, not on B/S of banks Takatoshi Ito ICRIER Feb 2009 18 Failed business models differences • Japan, commercial •US, investment banking banking – Housing Loan – Large investment bank Companies (Jusen) to fell fall first – Crisis spread to – Smaller commercial Fannie and Freddie, banks failed MMF, insurance – Four large banks failed company (AIG), Big 3 (1997-2003) auto companies, (and – Several rescue and more?) strategic mergers of large banks Takatoshi Ito ICRIER Feb 2009 19 Crisis Management, common pattern • Common pattern (S&L, Nordic, Japanese, and now the US) – Refuse to recognize (“No problem”) – Forbearance, Recognize, but regard it to be a small problem—no action – Try to take action, but fail to win public support (“Why tax payer’s money?”) – Action, but too little, too late – Big crisis happens and big action becomes possible Takatoshi Ito ICRIER Feb 2009 20 Crisis Management • Japan •US – Denial (1992 – 1995) – Denial – Forbearance – Forbearance • Jusen problem to all • (Aug 2007->March 2008) banking system – Recognize, try to act, but – Recognize, try to act, but no public support no public support • Bear Stearns rescue • Defeat of 685 billion yen • Refusal of first TARP in stop gap Senate • Distressed asset • TARP difficulty purchase—good bank- – Act, too little too late bad-bank model – Big crisis, big action – Act, too little too late • Change TARP to capital • Capital injection, No. 1 injection – Big crisis, big action • Make investment bank to • Public money injection 40 commercial bank (holding trillion yen company) • Capital injection N0.2 Takatoshi Ito ICRIER Feb 2009 21 Key moments, crisis management Japan US • November 1997 • September 2008 • Failures of Sanyo • Lehman failure Securities, Hokkaido – Financial institutions Takushoku Bank, and become skeptical each Yamaichi Securities other – Sanyo default in the call – Freeze of money markets market – Western Premium – Financial institutions • Legal framework was not become skeptical each ready other – freeze of the call market • Failed business model of – Japan premium investment banks (supervision mistake) • Legal framework was not ready (supervision mistake) Takatoshi Ito ICRIER Feb 2009 22 Key Moments: deposit guarantee Japan US • Blanket deposit • Deposit guarantee ceiling guarantee, 1995-2003 raised from $100,000 to • Capital injection into $250,000, proposed banks by the government, • Capital injection into 1998, 1999, 2003 banks by the government • Arrange rescue mergers • Arrange rescue mergers – Many regional banks – Bear and Stearns • Temporary nationalization • Nationalization? of banks, 1998-2003 –AIG – LTCB, 1998 – NCB, 1998 – Resona, 2003 Takatoshi Ito ICRIER Feb 2009 23 Key moments: Capital injection Japan US • Denial of capital injection, Feb • TARP was first voted down by 1995 the House of Representatives • 685 billion yen to help resolve • One week later, TARP was Jusen companies (small passed housing finance companies) • A few weeks later, an aim of were denied in the budget TARP changed from process purchasing distressed assets • Two years later, 40 trillion yen to injecting capital (preferred was needed to help large shares)